NOTE ON LEGAL EFFECT OF AMENDMENT TO SECTION 56(2) OF INCOME TAX ACT, 1961

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  1. NIRAJ JAIN

    NIRAJ JAIN New Member

    A BRIEF SUMMARY:

    The Union Budget 2012 has introduced a new clause in the Income Tax Act, 1961, according to which, with effect from April 1, 2013, that portion of consideration received for the issue of shares of a public unlisted company or private company to an Indian resident that is in excess of the fair market value of those shares, will be subject to tax in the hands of the companies under the head “income from other sources”.

    “where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares, in such a case if the consideration received for issue of shares exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares shall be chargeable to income tax under the head “Income from other sources”.

    The clause does not apply to:



    (i) A venture capital undertaking receiving the consideration for issue of shares from a venture capital company or a venture capital fund ; and

    (ii) A company receiving the consideration from a class or class of persons (‘Notified persons’) as may be notified by Central Government.



    Objective of the Amendment to Section 56(2) of the Income Tax Act, 1961

    The amendment has been classified under the heading “Measures to Prevent Generation and Circulation of Unaccounted Money”. Companies were issuing shares at a substantial premium to convert the unaccounted money without providing any valuation justifying the premium. The amendment covers such unjustified premium and the excess is being taxed as income of the company.


    How to compute The Fair market value

    Fair market value is defined as an explanation to the clause to mean:
    1. Value as may be determined in accordance with the prescribed method.(READ RULE 11UA)
    2. Value as may be substantiated by the company, to the Assessing Officer’s satisfaction, based on the value, on the date of issue of shares, of its assets.



    Simultaneous application of Section 68 and Section 56(2)(viib)

    In case of a closely held company, subscription to shares at a premium could attract:

    (i) Section 68 of the Act and oblige the company to explain source of source and if the Assessing Officer is not satisfied, the amount received(towards share capital and share premium) could be assessed as “cash credits” and included in the total income of the company; and

    (ii) Section 56(2) (viib) providing for the inclusion of excess consideration in the total income of the company.

    Prima facie, both the provisions can be applied as both of them are specific and provide for a specific treatment. However, on the principle that the same income cannot be taxed twice, an addition cannot be made, in respect of the same amount twice, by applying both the provisions. Either the entire amount may be treated as cash credit and accordingly assessed under Section 68 or the excess consideration may be treated as income under Section 56(2) (viib) and the balance amount (aggregate of share capital and share premium minus excess consideration, that is, to put it differently, aggregate of the face value of the shares and the share premium to the extent not considered as excess consideration) may be treated as cash credit under Section 68.

    If the amount is assessed as cash credits in the hands of the company, its assessment in the hands of the shareholders, as unexplained investment (under Section 69), may not be ruled out .




    Conclusion

    The amendment to section 56(2) of the Income Tax Act, as discussed above, will have an impact on the “resident angel investors” and not on investors who do not satisfy the test of ‘residence’ as per Section 6 of the Income Tax Act. Also, angel investors have the option to invest in convertible debt securities which are excluded from the purview of this amendment which covers only ‘shares’. Although the above discussed amendment to the Income Tax Act has a worthy objective of controlling the flow of unaccounted money in the economy but this has an unintentional effect on the investments made by angel investors which help in funding the start-ups as discussed above. The government has not issued the notification yet but the AIF Regulations have made it almost impossible for angel investors to fund start-ups in light of the restrictions and limitations imposed on the investments.
     
    Neha Sharma likes this.
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